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Recovery or Risk Aversion Redux In FX This Week?

Last week while US traders prepared to sit down to a peaceful Thanksgiving meal, the currency market became embroiled in the Dubai debacle sending risk FX tumbling from its year to date highs. With weekend news suggesting that Abu Dhabi may step in to help out with some if not all of the Dubai World debt problem, risk assets have rallied with EUR/USD once again trading above the 1.5000 level.

However, although the turmoil I the Middle East markets appears to have been contained for the time being, the story is unlikely to go away just yet. Many market observers have correctly pointed out that the scope of the Dubai World problem is miniscule in the greater scheme of things with liabilities in question equivalent to only 5 basis points of total US and European bank assets . Yet it is not the absolute value of the loss that is in question here but rather the psychological impact of the a possible default. Such a move could result in a rapid contraction of risk appetite across all capital markets which in turn could threaten the nascent global economic recovery.

Last week, economic data throughout the G-10 universe was generally positive beating market expectations and provided support for the risk rally that saw most of the high beta FX reach yearly highs against the dollar just before the holiday. The unexpected news from Dubai quickly unwound those trades and now the central theme this week in FX is likely to revolve around this tension between the recovery bulls anticipating yet further improvement in the economic data and the bears who are betting on resumption of credit crunch fears that will suppress any rebound in activity.

With the risk trade having rallied so strongly over the past six months, any disappointment in this week’s economic data starting with German Sales and Unemployment report tomorrow and ending with the US Non- Farm payroll number on Friday, could trigger a significant round of profit taking as investors and speculators try to lock in returns for the year. Although seasonal factors favor a further rally in the euro both on the end of the month and end of the year basis, this year the pattern may be different. With the risk trade having been essentially a one way bet since the bottom set in March, a correction is due. If the eco data this week misses to the downside, it could provide the catalyst for a further unwind in high beta FX.

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